Obtaining financing can be one of the most challenging aspects of building a home. That’s because construction project finance is more complicated than applying for a traditional mortgage.

Unless you have significant cash reserves, you will likely need to get a construction loan in order to build your new home. A construction loan provides you with the cash needed to finance new construction, but getting one isn’t always easy.

Construction Project Finance Basics

A construction loan is a short-term, interest-only loan. Once your home is built, the loan is replaced by a traditional mortgage.

There are two types of construction loans:

• An all-in-one loan. This kind of loan automatically converts into a mortgage once your home is finished. It is also called a construction-to-permanent loan.
• A construction-only loan. This loan finances the building of your new home, and must be paid off once construction is complete. It is then replaced by a standard mortgage.

Both types of loans have advantages. An all-in-one loan reduces paperwork and hassles, but a construction-only loan may offer better options for a mortgage, because you won’t be limited to the terms offered by the construction loan lender. Instead, you’ll be able to shop around for the best mortgage rate.

Obtaining a Construction Loan

If you want a construction loan, you need to be prepared to make your case to the lender. The lender will likely want to see a budget and other information, such as building plans and your contract with the builder. The total amount of the loan will be based on the anticipated future value of your home.

No matter what kind of loan you get, you will pay a fixed interest rate for the life of the loan (usually 12 or 18 months). The interest rate you pay will depend on your credit rating and financial situation. You’ll also have to pay loan origination and other fees, which can range into the thousands of dollars.

Once your loan application is approved, the funds will be disbursed according to a schedule. The money is released so you can pay the builder once the work (such as pouring the foundation or framing the house) is complete.

Building Finance Strategies

How much you choose to borrow to build your home is a personal decision. While it may be tempting to borrow as little as possible, that’s not always the best approach. You don’t want to get a small loan and then run into cash-flow problems toward the end of the building process.

Whether you purchase a lot before or after you get a loan is also an important decision. In some cases, it may be advantageous to wait until you have a loan to buy property, as you won’t have to deplete your personal cash reserves before building begins. Whatever type of finance for construction you choose, you’ll want to do your research before making a decision to be sure you’re getting a loan with the best possible terms.